Life Insurance: How Much Is Enough?

February 11, 2012 07:20 AM

Adequate life insurance ensures financial security

Leaving a legacy requires strategic, big-picture planning, which includes preparing for the worst. For farm families, an unfortunate event such as a death can jeopardize financial security. That’s where life insurance comes into play.

Legacy Pioneer BadgeAccording to a study by the Life Insurance Marketing Research Association, more than 6 million households in America do not have a life insurance policy. As a result, 22% will have immediate trouble with daily expenses and another 26% will be able to meet financial needs for only a few months if the primary wage earner dies.

Farm families have too much on the line to go without life insurance. Farm Journal Succession Planning Expert Kevin Spafford says life insurance is "designed to provide money when it is needed the most."

To determine how much life insurance coverage is necessary, address the following five key areas:

1. Final expenses. How much money will your family need to tie things up after you pass, including funeral costs and unreimbursed medical expenses? Do you have outstanding debts that your loved ones will be left to pay? Are there special needs or educational funds that might need to be included in the total calculation?

2. Income replacement. Should the sole wage earner of the family pass, how much money would be necessary to meet the family’s basic needs?

Spafford says there are two ways to calculate this figure. Using the first method, assume a monthly income need. Multiply that amount by 12 and then divide the result by an assumed investment rate of return to determine necessary income replacement. In the second method, you would take the monthly need, multiply it by 12 and then again by a set number of years.

3. Overhead expenses. Should the primary operator die, how much money would be necessary to ensure that all overhead costs are met to keep the business running? This is generally set up like an income replacement fund, Spafford says, but it is used only for a specific number of years.

4. Estate tax and transfer obligations. When compared with historical figures, today’s estate tax rates and exclusion limits are lower. With the current exclusion at $5 million and a 35% tax rate, the calculation is simple. For example: A couple with a $20 million farm each receives a $5 mil-lion exclusion, so only $10 million is subject to tax. At a tax rate of 35%, that leaves $3.5 million to pay in taxes.

5. Administrative expenses. Who will manage your estate when you pass? Generally, probate fees are involved while your estate is being settled. How much money will be needed to cover those expenses? Include that amount in your life insurance policy, if possible. Spafford says this figure is generally calculated as a percentage of the gross estate. Using the previous couple as an example, $20 million times a 7% probate fee equals $1.4 million necessary to settle the estate.

Am I too young for life insurance? You are never too young for life insurance, according to Spafford. "It is to be purchased while in good health and paid for with money," he says. Those
in poor health are ineligible.

Life insurance is not a fix-all, but it is often recommended as part of a comprehensive succession plan along with a buy-sell agreement and an estate tax strategy in case of a pre-mature death. Sit down with your insurance provider, your succession planning adviser and your attorney to plan the best possible outcome for the worst possible scenario.

Covering Business Risk

According to Josh Sylvester, a Certified Financial Planner and member of the Farm Journal Legacy Project team, there are several ways to use life insurance to cover risk and fund farm succession plans:

  • Insure against the loss of a key employee.
  • Fund a deferred compensation agreement for a key employee.
  • Finance a redemption or a cross-purchase buy-sell obligation.
  • Provide estate liquidity so that heirs who are not active can receive nonbusiness assets and heirs who are active can receive the business.
  • Help fund the payment of estate taxes.
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